Wednesday, 30 September 2009

A few weeks ago, I noted research results which concluded that there is no automatic, direct relationship between GDP growth and equity market performance, and I cautioned against jumping too fast into investments in China, India and Russia.

Now along comes global consulting firm McKinsey & Company with its annual Global Capital Markets review (summary here with link to full report, which is free upon registration) with the view that Emerging country Equity Markets will grow considerably faster than major developed markets like the USA, the UK, Eurozone and Japan (Canada is too insignificant to merit much of McKinsey's ink). Notable quote: "... asset classes in mature markets are likely to grow more slowly, more in line with GDP, while government debt will rise sharply. An increasing share of global asset growth will occur in emerging markets, where GDP is rising faster and all asset classes have abundant room to expand." Equity is one of the asset classes they discuss.

McKinsey cites several reasons for thinking that equity in emerging markets will do better:

high savings rates in those countries mean a lot of money is available to invest and equity is better placed than debt to be the investment vehicle

these countries have great needs for infrastructure construction

financial markets in emerging countries are still quite small compared to GDP and thus have much room for growth

many state-owned enterprises have yet to be privatized

Along with the big constraint of the government and private debt burden in developed economies, McKinsey see higher inflation as a risk. They see little hope of big gains in equities: "These projections give little support to the hope that corporate earnings and valuations will rise again to significantly and sustainably higher levels in mature markets ."

It seems that McKinsey may not be alone in coming to such conclusions. The rebound in Emerging Markets has been much stronger since January 1st, as the iShares' Emerging Markets Index Fund (EEM) has outstripped such developed market ETF indexers such as SPY (S&P500), VGK (Europe) and XIC (Canada) in the Google Finance chart below.Admittedly, Emerging Markets did fall off much more drastically during the crisis last fall but they have still outdone the developed ETFs from just before the worst moments of the crash, between August 1st last year and today, as this second Google chart shows.

Thursday, 24 September 2009

Sadly, the answer is that financial advisors hinder according to Do financial advisors improve portfolio performance?, a just-released study of German investors at Vox by university professors Andreas Hackethal, Michalis Haliassos and Tullio Jappelli. The reason is the old bugaboo - costs and fees.

Advisors add value but ... "Even if advisors add value to the account, they collect more in fees and commissions than they contribute." Apparently the authors found that richer, older people tend to use advisors more which accounts for a preliminary gross conclusion that "Investors who delegate portfolio management to a financial advisor achieve on average greater returns, lower risk, lower probabilities of losses and of substantial losses, and greater diversification through investments in mutual funds." They note that the financial industry would love to grab that statement for publicity. However, the net truth is completely opposite: "Once we control for different characteristics of investors using financial advisors, we discover that advisors actually tend to lower returns, raise portfolio risk, increase the probabilities of losses, and increase trading frequency and portfolio turnover relative to what account owners of given characteristics tend to achieve on their own."

Of course, that does not mean that all advisors are bad for your financial health. It does mean choosing carefully, however.

Wednesday, 23 September 2009

There has been a nose-to-nose yelling match going on between the mutual fund industry and the Ontario government about the extra costs that will result from the Harmonized Sales Tax. But that's not all the HST will affect.

"There are many investing-related services that are currently subject to the Goods and Services Tax (GST), but not provincial sales tax (PST). These services will probably be subject to the HST, a combined PST/GST tax that effectively increases their cost by 7% in BC and 8% in Ontario. Here is a partial list of services that will likely be impacted:

1.RRSP, RESP or RRIF administration

2.Setting up and holding your mortgage in your self-directed RRSP

3.Transferring securities to another institution

4.Mutual fund and portfolio management

5.Financial, tax and estate planning

6.Changing the beneficiary in an RRSP, RESP or RRIF

7.Searching records and providing copies of account statements.

Concludes Bebee, “Investors should lobby their investment dealers for price reductions to compensate for the pending HST increase. Businesses can afford to drop prices because the new tax regime will significantly reduce business costs.”

***********************************************Another frustrating development comes from Sprott Mutual Funds for clients of Questrade. Questrade PR person Lynn Suderman sent along the following blurb with which I can only concur. (Note, I do have an account with Questrade but don't own any Sprott funds)

"As you may recall, Questrade launched a Mutual Fund Maximizer service (with trailer fee rebates) in January. As of yesterday, September 16th, Sprott Asset Management decided to block the purchase of any Sprott fund by Questrade clients and will no longer be paying the trailer fee rebate. Why? We’re not entirely sure – their reasons are vague. No other mutual fund company is blocking sales of funds or trailer fee rebates.

Attached is a bit of background on the issue. Questrade will be pursuing all available avenues to reinstate Sprott funds and Sprott trailer rebates to our clients. In the meanwhile, I thought you may be interested in this turn of events. Note that Jonathan Chevreau wrote about it in his blog today:

I’m hoping to encourage people to lodge complaints with Sprott, the Competition Bureau, OSC, etc – see if we can get this overturned!

This is part of the email sent to our clients who own Sprott:

If you would like to show your support for Questrade and our trailer fee rebate program, we invite you to contact Sprott and the regulatory bodies that oversee our industry. Their contact information is below. Please remember to copy (cc) your letter and emails to marketing@questrade.com.

Tuesday, 22 September 2009

Big bucks but big bang. Conserving Client Portfolios During Retirement costs $65 USD but does it ever deliver value. Both the content and the presentation are superb. Bengen applies his experience as a financial planner working with real individual people to thoroughly cover the many aspects of making investment money last through retirement. He does the work of an author brilliantly, which is to be clear about assumptions and methods, state caveats and limitations but then to digest and distill the data. The result is a compact 165 page small format large print volume with dozens of tables and graphs. Those illustrations are the condensation of what he says believably are thousands of hours of calculation work. The prosaic title (the chapter headings are the same) characterizes the writing style - plain and direct but crystal clear. There is nothing fancy about the book - no jokes or coy titles, no famous quotations, no hot tips or investor alerts, no sidebars or key points summaries. You could say that it is all steak and no sizzle, except that the content itself sizzles.

The Content: Bengen's book is about the narrow but critical topic of how to get the most withdrawal cash out of an investment portfolio without exhausting it prematurely. His fundamental assumption is that the past is the best guide for the future. Using US index data for stock, bond and Treasury bills from the Ibbotson yearbook from 1926 onwards, he systematically tests how well all sorts of portfolios and strategies would have fared. The key metric is what he calls SAFEMAX - the maximum annual withdrawal as a percentage of the portfolio at start of retirement that would have ensured portfolio survival no matter what year retirement started.

The Bengen Variations (somewhat akin to Bach's Goldberg variations): these are all the conceivable options taken in turn to see what effect each has on the base case withdrawal rate of 4.15% (yup, he states two decimal points - is it obvious he started his career as an engineer?)

asset allocation - varying proportions of asset classes - large company stocks, small company stocks (can boost SAFEMAX up to 4.55%, a 0.4% gain), intermediate term US government bonds, long term government bonds (don't help at all) and US Treasury bills (can substitute for the intermediate bonds)

time horizon - in five year increments from 10 years to 50 years (a forever portfolio can sustain 4%)

reduction in safety (frequency that portfolio would not have survived and shortest longevity) from higher withdrawal rates up to 8.75%, where he cuts off around a portfolio has only a 50-50 chance of surviving the target duration

alternative withdrawal strategies - 1) withdrawing more during early active retirement years instead of a constant inflation-adjusted amount throughout (not very attractive as the later year penalty is too great); 2) fixed percentage of the portfolio every year (looks unattractive due to large variations in withdrawals); 3) floor and ceiling withdrawal amounts to take less during bad years and more during good times (looks pretty good)

active investing out-performance and under-performance by + or - 2% per year (really gives pause to think whether any but the passive index approach is worth pursuing)

how much to lower withdrawals in order to leave a legacy

value of reducing equity allocation during retirement (not worth it)

making adjustments to withdrawal rate during retirement (it's essential to monitor and adjust if things get too bad and it's possible to boost the safe rate as you get older and life expectancy declines) but ...

bear markets "... the intervention of a major bear market does not have to undermine a client's previous plans for withdrawals during retirement, assuming he initially planned to withdraw at SAFEMAX."

taxation of the account - using accounts whose effective tax rate was zero (the base case, like a RRIF), 20%, 35% and 45%; the tax Engen computes would be coming from inside the account, taken out of the portfolio before withdrawal

historical fall in dividend yields from rates above 5% up to the 1950s to about 2% in recent times (don't worry, makes no difference)

withdrawing once a year or every quarter

retiring date and withdrawal start at beginning of year or at beginning of various quarters - " ... a difference of only one quarter in the date of retirement can have a major effect on the longevity of a portfolio"

rebalancing frequency from every three months to almost 12 years (about every four years seems best)

whether or not to shift asset allocation (e.g. more fixed income) in anticipation of upcoming retirement (read it and find out!)

The final chapter sets out three case study scenarios based on Bengen's experience dealing with his clients, showing the actual application of the principles. Due to quite different life goals, like travel, donations, inheritances, the recommended initial withdrawal rates vary considerably from and seem to be appreciably higher from the base case 4.15%. Yet Bengen obviously thinks these would work ok since he insists on the importance of leaving a substantial margin of safety in choosing how much to withdraw. There is one improvement to this chapter I'd like to see: instead of calculating a future model portfolio value using average past returns for every year, Bengen should show what happens in the worst case scenarios of past markets. People who see a projected portfolio that continues to rise in real terms with steady 8.3% in returns every year might scale back their initial withdrawal rate considerably if they see that a severe bear market combined with high inflation, such as happened in the 1970s, could bring them close to portfolio exhaustion.

Another caveat is that actual investment returns modeled on indices such as the Ibbotson data used in this book, cannot and will not be achievable. Bengen does not name any mutual funds of ETFs an investor could actually buy. Though the costs of running the mutual funds and ETFs will theoretically lower their returns by that amount and cause them to systematically under-perform the index, it seems that some funds like the Vanguard Small Cap ETF actually outperform the index (see Seeking Alpha's Indexing: Mutual Funds vs. ETFs and Beating The Benchmark). So it's hard to say absolutely that using index returns is an error.

Many mutual funds, especially those in Canada with outlandishly high fees, are wont to seriously and continuously under-perform. Bengen's chapter 7 on chronic under-performance from active management gives us a way to estimate the penalty - e.g. a 60% equity portfolio with a 30-year horizon would have to reduce the withdrawal rate by 0.3% to compensate for a 1% decrease in average stock returns.

A Canadian investor trying to emulate the same investment approach with the TSX index and Canadian bonds might not be able to achieve exactly the same returns. We could not thus expect to set a sustainable withdrawal rate quite as high as Bengen describes for US investors since Canada's real returns on equities and bonds have been slightly less than the USA's over the period 1900 to 2008 per the Credit Suisse Global Investment Returns Yearbook 2009 by Elroy Dimson, Paul Marsh and Mike Staunton.

Another limitation, which he admits freely in the book, is that other asset classes now available were excluded from the analysis due to lack of long term historical data. He does say that he believes those additional types of assets probably would benefit retirees' portfolios but they are not modeled.

A final caveat is that the scenarios assume that other sources of income, notably annuities, are taken as a given, but in fact, a key choice for a retiree is how much of a retirement account to annuitize, as Moshe Milevsky points out in his recent book Are You a Stock or a Bond? A portfolio does not stand alone as a source of returns, inflation protection or reduction of income variability.

The book is addressed to financial advisors but every individual intending to manage their own investments in retirement will benefit enormously from buying it.

My rating (à la Bengen): 4.83 basic plus 0.17 boost for the many blog post ideas it gave me = 5.00 out of five stars

Postscript: Bengen is a fee-only advisor. When I sent him an enquiry form on his website to ask about some aspects of the book, within an hour he sent an email saying I should phone, which I did and lo and behold, he was there and took my call. If he does that for a lowly blogger I bet his clients are happy, not to mention well-served by the application of the knowledge in this book.

Monday, 21 September 2009

Ever wonder what was the worst possible time to retire? Most people might guess that it was around the time of the Great Depression of the 1930s. That's wrong. The generation of retirees hit hardest since the 1920s was that starting retirement in the mid to late 1960s, just before the perfect storm of the 1970s, which combined a severe bear market in 1973-74 with a period of high inflation. The double whammy of lower equity values along with higher withdrawals to maintain a lifestyle would have depleted a 60% equity 40% bond portfolio about 5 years faster than the worst possible quarter to start retirement during the late 1920s. It wasn't just one or two quarters of retirees that suffered, it was a whole generation of those retiring from about 1962 to 1972. I came across this surprising fact in William Bengen's book Conserving Client Portfolios During Retirement (see figure 5A on page 58). Jim Otar's new book Unveiling the Retirement Myth available at his Retirement Optimizer website shows the same result (page 115 of the green online version, in the chapter on inflation).

It's a reminder to retirees to be concerned about inflation. The last dozen years or so, inflation has been very stable and low - around 2% per year. But will that continue? Certainly it is a central objective of governments but will they be successful in containing inflation if government deficits and borrowing grow out of control?

Saturday, 19 September 2009

Investors like me who merely seek to replicate the returns of a broad index and not to time markets but merely passively track the index often use ETFs to do so. It's probably no surprise that ETFs vary considerably in how well they do the job of tracking the target index. The measure of the deviation from the index is tracking error.

Forbes' ETFs Behaving Badly article and accompanying 20 Best and 20 Worst slide shows describes results of a survey of 505 US-traded ETFs done by Morgan Stanley for 2008. In many of the worst cases the tracking error is several percentage points. The best have really tiny tracking errors.

Many of the worst trackers turned out to have out-performed or done better than the index in 2008. The article explains how some of those came about which gives me the sense that it's likely to keep happening. It's perhaps a nice accident that some results were better than the index in 2008 but in future years an uncontrolled or uncontrollable tracking error could well mean serious under-performance. Just give me the index please!

Most of both the best and worst lists are quite specialized ETFs. It's reassuring to see that among the best are Vanguard's Total US bond market ETF (BND) and iShares US TIPS Inflation-Indexed Bond Fund (TIP). A surprise is that some of the worst are several Vanguard offerings like their Energy Fund (VDE) and a Telecomms Fund (VOX) and an ETF heavyweight, iSharesMSCI Emerging Markets Fund (EEM). There are also several bad country trackers, notably iShares' ETFs for Mexico (EWW) and Austria (EWO) and the SPDR S&P China fund (GXC).

Wednesday, 16 September 2009

What's Wrong with Judging Investment Performance with an IndexOne of my pet peeves is articles about investment performance based on the price variation of indexes such as the TSX, the Dow or the S&P 500. Unfortunately they do not reflect real world individual investor experience. Though it is possible to buy ETFs or mutual funds whose objective is to track an index, such things as trading costs / commissions, tracking error, bid-ask spreads and distributions can cause actual results to vary from the index.

Another thing I find annoying is that people often limit themselves to indexes for only two asset classes - stocks and bonds. We've all seen the classic 40% bonds, 60% stocks. There are a lot more asset classes out there with which to diversify, like real estate (REITs), real return bonds, foreign developed or emerging market equities (which introduce the issue of currency hedging), small and value cap tilts, commodities. Current theory says we should take advantage to maximize diversification and the ETFs are there to allow the average investor to do that, so why not model it?

Another issue of note is whether and when to rebalance a portfolio. Would a policy of reviewing the portfolio every December, and rebalancing if too much out of sync with target allocations, have done better than simply buying and holding?

Finally, the recent (on-going?) financial crisis and market crash provides a real high stress period in which to see how various realistic portfolios fared.

Assumptions: So, I've done some calculations in as realistic a way as possible. I started with $100,000 in May 2007 before the troubles really began and took it to the close last Friday, September 11, 2009. The portfolio is split 70% equity, 30% fixed income, with finer sub-divisions of both for the 4- and 16-asset portfolios. I used passive index ETFs available on US exchanges and the TSX.

The USD-CAD exchange rate I've used is based on the mid-market closing rate, which I've adjusted for the initial purchases by adding 1% to approximate the foreign exchange fee embedded in Canadian broker rates. At the Dec.17, 2008 rebalancing date, I have not adjusted for FX since almost all of the FX fee could be avoided by doing wash trades offered by most brokers and/or keeping the USD distributions in a USD account when received, as all brokers allow for non-registered accounts and some do for registered accounts. Also I have not deducted any US withholding tax from the US ETF distributions, which is ok for ETFs held in registered accounts but not in a TFSA or a non-reg account. So that assumption might slightly overstate returns depending on the account in which a portfolio is held.

As to rebalancing, I modeled none in Decmeber 2007 because the ETFs had not strayed far from their May target percentage allocations. Ths cash distributions were merely accumulated in the account. I ignored interest on the cash since it would have been too little to matter. ... all this stuff about my assumptions shows why so many people don't like taking the trouble to do realistic calculations - it's painstaking!

Results:

big surprise, the simplest portfolio, consisting of only the iShares S&P/TSX 60 Index (XIU) and the iShares ScotiaCapital DEX Bond Index (XBB) fared best in every way!! It dropped the least to the review point of Dec.17, 2008 and has recovered almost fully (less than 1% below) to the starting value. That's why I've named it the "KISS Me Quick" portfolio - It has treated you well - who doesn't like a kiss!? It's KISS = Keep It Simple Stupid and it sure is quick to implement.

big surprise again, the more diversified the portfolio, the worse the results! Huh, I though diversification was supposed to help, but whether or not the strategy was buy-and-hold or rebalancing, the fancy 16 asset portfolio did worst: it dropped the most and has receovered the least. That's why it's called the "Diversification Guru" - we all know what gurus are really worth.

wow, rebalancing really worked well. In the short time since last December, all three rebalanced portfolios have outdone the buy-and-hold approach by anywhere from 7% to 9%.

no surprise, diversification by holding fixed income is a lot better than just equities; if only XIU had been in the portfolio, there would have been a 31% drop in value, even including distributions. That's much worse than the 22% fall of even the worst portfolio, the 16-asset version. And XIU as of Sept.11th was still 14% below its initial value of May, 2007. The strong recovery of XIU has not made up the ground lost up to December. The reason is that no rebalancing occurred, as it could not with a single asset.

Why More Diversification Didn't Work

real estate and foreign markets - some of the extra asset classes fell harder than Canada's; the UK's banks made up a bigger chunk of the FTSE index and they had just as much trouble as US banks

currency shifts - up to last December, the CAD's big drop relative to USD as the flight to safety occurred cushioned some of the blow of drastically falling stock markets but since then the strength of CAD (check all the blue appreciation of the last 3 months at RatesFX) has limited the upside.

Further Thoughts:

the future may not be like the past - this time and in this relatively short period, it was bonds, particularly government bonds, that provided the critical diversification benefit. Safety of principal was the issue. That may not be the case if inflation for instance, is the next big threat. In an uncertain world, different assets for different threats is still my best guess at what will allow me to survive if not thrive quite as much as the strategy which has worked best in retrospect.

Monday, 14 September 2009

Through a sad and bizarrely crazy new set of immigration rules, the WWB (World Wide Bureaucracy) has struck again in the UK as a happily and voluntarily married young Canadian-Welsh couple will be obliged to live apart for a couple of years due to regulations supposedly designed to protect young British women of Pakistani or Bangladeshi origin from being forced into marriage. The woman involved is not British (she's Canadian), she has no Pakistani, Bangladeshi or any remotely Asian roots by all appearances ... I know, I know, I'm revealing my deep prejudice by coming to that conclusion by looking at her name (Wallis), her white face, her red hair ... and both she and her husband vehemently deny any coercion to get married.

She's not especially young either, being 19 years old, and sounding rather mature in the BBC news interview found in the above link. It's interesting that UK law permits 16 and 17 year olds to get married with their parents' permission. Above that age, Brit teens can marry if they like. By the logic of the regulations which deny marriage visas to foreigners under 21, the implication is that pure Brit teens are superior to non-Brits.

This case leads one to wonder if the new regulations were cast in such an un-necessarily broad ill-fitting manner to adhere to political correctness and avoid singling out a particular country or ethnic group. The "for the greater good some have to suffer" explanation put forth by the Home Office is laughable. Since all of the cases cited in the What is a forced marriage? booklet of the Forced Marriage Unit website involved teens travelling to another country, maybe the government should simply have banned all foreign travel by British citizens under 21?

As a Canadian who, though considerably older than this couple, came to the UK through marriage to a British citizen and experienced frustrations dealing with the Home Office in getting the necessary visas, I have a great deal of sympathy for Adam and Rochelle. I really hope their problem gets sorted, though the bureaucratic stonewalling and circling of wagons to back up the idiotic Home Office regulations is all too evident in the BBC account.

Tuesday, 8 September 2009

Annuity rates move more or less in tandem with interest rates - as interest rates fall, so do annuity payouts. Not long ago, the IFID centre posted a time series going back to 2000 showing sample annuity payouts and implied longevity yield, described as a measure of an annuity's return. It's a handy and welcome way to judge the trend and whether things are getting more advantageous for a retiree to turn a lump sum into an annuity. The recent trend seems to be upwards towards higher payouts e.g. a 65 year old male could get about $680 monthly income at the end of June (it's the latest data apparently) per $100,000 initial premium versus $650 or so last September. The highest it has been was about $740 in 2000-2001 so there is some way to go before rates get really attractive.

It is also worth noting that it is essential to shop around. Cannex has one freebie table of current annuity rates offered by the various providers showing payouts for a single life male with a 10-year guaranteed payout. There is a wide range - a 65 year old can get as little as $594 monthly from Standard Life to as much as $667 from Canada Life or Great_West Life, a 12% difference.

Monday, 7 September 2009

A bit strange this book is. On the one hand it has a great deal of explanation and links to sources on macro-economic indicators and trends, how they affect markets and how investors can use them to advantage. On the other hand, it steadfastly maintains that such an approach is simple and easy for the average investor.

I really doubt that somehow. How many investors are willing to take the time and trouble to regularly monitor and read no less than 40 top-down indicators? How many will be able to correctly remember all the inter-actions and implications to properly interpret the data therein in order to find the appropriate investment target sectors? How many will know where to find the investment target securities?

An example to illustrate the challenge: on pages 164-169, Crescenzi analyzes the then (June 2008 or thereabouts) subprime mortgage situation and begins with a comment that credit default swap indexes were priced for defaults on such mortgages to reach as high as 40%. Huh, how did he figure that out? If that is the basis for a judgment that the market at the time was over-reacting, we the investor would have to be able to estimate that too. But one would need to know what a credit default swap is, then know where to obtain the data, then to know what calculation to perform to estimate the 40%. And finally, of course, there is the bigger issue that instead of over-reacting, maybe the market at the time was under-reacting given the crash that resulted from September onwards.

I daresay the average investor will find it challenging, perhaps overwhelming. Crescenzi, as a top investment strategist (he recently got hired away by the famous PIMCO from the Miller Tabak, which is listed on the dust jacket as his employer), may find it easy from years of learning and observing and may even be very rich from carrying out his own recommendations. I think it does a disservice to himself and to his audience to pretend it is simple and quick. The get-rich-quick message isn't required and casts a shadow of suspicion that the whole approach is just a scam. He also harps on about how it is much easier than bottom-up value investing, an unnecessary distraction to the reader who just wants wants to know how to do it.

This is really a book for the committed active investor, the afficionado who is looking for another angle, another method or set of tools to find the winners. It will not appeal to those convinced that passive index investing is the surest, though slow, route to investing success.

To a degree, it will also interest those who like to read and understand their economic and financial world. I enjoyed finding many more informative and useful websites and sources of key data.

Thursday, 3 September 2009

There are ETFs for just about everything these days. Amongst the country, commodity, sector and bear/bull ETFs, there are Socially Responsible ETFs.

To cater to those who view the SRI funds as political correctness and who love to decry it, in the spirit of equal opportunity I would like to modestly propose the creation of another one that presents the opposite point of view - the Shunned and Sinner Index ETF. One has to admit, it has a certain ring to it, or more precisely, a TWANG - tobacco, weapons, alcohol, nuclear and gambling.

The S&S ETF investor need not sacrifice for his or her unpopular personal point of view. No indeed. In their paper, The Wages of Social Responsibility, found over at the Social Investment Forum (Ah, the world is full of ironies, isn't it. This very paper that won the 2008 Moskowitz Prize for Socially Responsible Investing confirms that you can make money by doing the opposite), researchers Meir Statman and Denys Glushkov found that "... we also find that ‘shunned’ stocks outperformed stocks in other industries". They cite another study by Harrison Hong and Marcin Kacperczyk called the Price of Sin that found "... that the realized returns of ‘sin’ stocks were higher than the returns of other stocks." These 198 baddies stocks include GE (weapons and nuclear), Coca Cola (alcohol ... so that's the secret ingredient!), Altria (tobacco and alcohol) and Harley Davidson (gambling ... really? riding a bike isn't that dangerous).

An S&S ETF would allow investors to add a Mean tilt to their portfolio to supplement the oft-noted Value and Small Cap tilts. It's time to jump in now, before the efficient market discovers the S&S effect and eliminates it through arbitrage.

We can all have our cake and eat it too though, since Meir and Glushkov also found that the SRI approach can do well by focusing on companies with good community and employee relations and high scores on environmental responsibility. Everyone wins, no one loses, now that's politically correct.

How about it, iShares, Powershares, Claymore isn't there an unexploited opportunity and a clientele to be served?

Wednesday, 2 September 2009

Countries experiencing rapid economic growth like China, India and Russia should be a good place to get higher stock market returns than stolid slower-growing places like Europe, right? Oops, not so fast.

Apparently, it ain't so. There is no relationship between a country's high GDP growth and stock market returns, especially not in the long run and only weakly in the short run. In Economic Growth and Equity Returns from SSRN, professor Jay Ritter calculated that there was in fact a negative relationship between economic growth and stock returns in 16 major countries (including Canada and the USA) over the period 1900 to 2002 - this chart is taken from the paper.

Other people have found the same thing, focusing on the USA - Crestmont Research's It's Not the Economy has a decade by decade chart showing the unpredictable differences in the same or opposite directions. CXO Advisory in Update: GDP Growth and Stock Market Returns tried calculating leads and lags to see GDP predicted the US market or vice versa and found that didn't really explain much either. In Canada, CIBC's Economic Insights of August 25th has this scatter plot which again demonstrates the same point.Ritter's explanation is that consumers and company managers get the benefit of GDP growth, not stockholders.

He also makes the dramatic statement that past stock returns are of no use in predicting future returns!

The main metric that does predict future returns according to Ritter is the smoothed earnings yield (taking a 10 year average of earnings to eliminate business cycle effects) i.e. Earnings / Price. "A low smoothed earnings yield does, however, predict low real stock price growth over the following ten years. In other words, P/E ratios revert towards the mean through price changes rather than earnings changes." The only caveats that could derail that relationship would be: if managers and employees take the profits due to shareholders (are shareholder rights well protected?) and; if some catastrophe like war, revolution, hyperinflation destroys the value of financial assets. Based on the numbers in 2004, Ritter said that real annual compounded stock returns would average 4.5% instead of the historical 7%. Crestmont's little blurb attached to their chart also says it's the P/E that matters.

Wish I had the data to do the calculation for today's markets. The Price part of the equation is down quite a bit, such that the E/P will be lower but is it enough to produce good future equity returns?

In any case, these studies suggest strongly that the assumption that China's rising economic success means assured investing success is wrong and likely to disappoint.